Euro crisis turning point: Two years of Banking Union

Europe’s banking union, constituting a supranational pooling of most instruments of banking policy, was established two years ago, in the early hours of June 29, 2012. To a greater extent than was initially realized by most observers, this step marked a watershed in the European crisis by making it possible for the European Central Bank (ECB) to stabilize sovereign debt markets. The banking union will also profoundly reshape and realign Europe’s financial system and institutions, with consequences that will unfold gradually.

The summit declaration establishing Europe’s banking union made three points: the intent “to break the vicious circle between banks and sovereigns”; the integration of banking supervision within the ECB; and a suggestion that the European Stability Mechanism (ESM), the euro area’s common fund, would be allowed to recapitalize banks directly under certain conditions.

Developments in Spain soon encouraged cynicism about direct ESM recapitalization. Investors only started releasing the pressure on periphery sovereign spreads four weeks later, when Mario Draghi, the ECB’s president, pledged to do “whatever it takes” to defend the euro area’s integrity, a stance later formalized as the Outright Monetary Transactions (OMT) program of conditional sovereign bonds purchases.

But even though the definitive history of these crucial weeks of mid-2012 has yet to be written, and the ECB is bound to present its policy decisions as independent from the political process, it is doubtful that OMT would have been possible without the prior announcements on June 29.

In a recent speech, European Council President Herman Van Rompuy stated that “the Central Bank was only able to take this [OMT] decision because of the preliminary political decision, by the EU’s heads of state and government, to build a banking union.” In October 2012, Mr Draghi described OMT as a “bridge” that “must have a clear destination” and said the single supervisory mechanism was “a key step” in defining that destination. This follows a pattern of ECB actions coming after political breakthroughs: its Securities Markets Program came after the European Financial Stabilization Facility’s creation in May 2010, and the implementation of three-year Long-Term Refinancing Operations was undertaken after the Fiscal Compact in December 2011.

Subsequent developments have demonstrated how much the banking union was a game changer. Granted, the commitment about ESM direct recapitalization was gradually deprived of any substance. But the centralization of supervision at the ECB has been enshrined in remarkably strong EU legislation. The future bank resolution framework, with a European resolution agency to be created next year in Brussels, is an awkward compromise between national and European decision making and funding. But it strengthens the prospect that creditors will share a larger part of the future burden of restructuring failing banks than has been the case in Europe so far.

A new banking levy is a notable case of introduction of a quasi-fiscal resource at the European level, and a much sounder one than the headline-grabbing but ever-postponed financial transaction tax. Crucially, the ECB’s supervisory role is front-loaded with the ongoing comprehensive assessment of the bulk of the euro area’s banking system, which is likely to end (belatedly) the systemic fragility impairing credit in Europe for seven years. Beyond this transition, the ECB’s indifference toward protecting national banking champions, or forcing banks to buy specific countries’ sovereign debt, is expected to lead to stricter supervision and market discipline, cross-border financial integration, and less reliance on banks in the financial system.

Banking union is no panacea. The ECB could still be less than rigorous in its bank review this year, which would squander the opportunity to restore trust. Several countries face disquieting medium-term economic, social, and fiscal prospects. Perhaps the wildest card now that perceived sovereign credit risk has abated is that EU institutions remain in a state of flux. As the center gains increasing discretionary authority, new channels of democratic accountability must develop. The recent appointment process for the European Commission’s president represents a response to this need through the empowerment of the European Parliament. But this trend is exacerbating the tension with the United Kingdom, which has not yet adapted to what Chancellor of the Exchequer George Osborne memorably called the “remorseless logic” of political integration in response to the crisis.

Even so, the anniversary of Europe’s banking union is worth celebrating. Two years ago, and for lack of alternative options, Europe’s leaders avoided their usual muddling-through complacency to do something radical—and it worked. They may need to muster such stamina again.